Economic Puzzle Involving Stock Ownership, Part I

On the table in front of me sits an unsealed, transparent envelope. The envelope is labelled as follows :

This Envelope and Its Contents are the Entire Assets of the Public Stock Company Known as The Transparent Envelope Company, or TEC.

In my possession I have a stock certificate for 1 (one) share of TEC.

In the envelope, there are two $5 Federal Reserve Notes and a stock certificate for 1 (one) share of TEC, identical to my own.

No other TEC stock certificates exist in any form, anywhere.

Across the table from me sits my brother, who has neither stock nor money.

Question #1 -- What total price and price per share would a third party buyer be willing and required to pay for the entire company, assuming that he were willing to accept no gain or loss?

Question #2 -- There are four possible distinct distributions of a single item in the envelope to either my brother or myself, i.e. a $5 Federal Reserve Note or a stock certificate for 1 (one) share of TEC. For each of the four possible distinct combinations of item and recipient, determine the change in the total price for the entire company that would result and label each particular combination with what it could be called if it were a real transaction of a real public stock company.

a. $5 FRN to me --
b. $5 FRN to my brother --
c. Stock certificate to me --
d. Stock certificate to my brother --

END



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Don, Since nobody else has

Don,

Since nobody else has come forward with an answer, here is mine.

As far as I am concerned, the 1 share stock certificate inside the envelope is meaningless when the envelope is closed. The total value of the company is $10, from the two $5 FRNs in the envelope.

Answer #1 - A third party should pay $10. Since there is only one share when the envelope is closed, the price would be $10/share.

Answer #2 -

a. (-$5) - dividend
b. (-$5) - expense
c. no change - stock split
d. no change - stock grant or secondary public offering

Jonathan, Except for the

Jonathan,

Except for the secondary stock offering, which would bring in revenue, everything is correct.

As a reference, I will expand on the answers.

Question #1 --

When a company holds its own, undistributed stock, it has no value to the company itself, and it has no consequences to anyone else either.

There are really two, independent reasons why this is true. First, a company cannot own itself. Any shares that the company happens to hold are really the property of all the external shareholders, and thus have no effective existence. Secondly, the company is effectively free to create new shares without limit, although technically subject to shareholder approval. Thus a company's own shares have no scarcity value to it. In this regard, it is usually added that the company suffers little or no difficulty or expense in creating new shares, but even if it created new shares in an extremely expensive manner, the resulting shares still wouldn't be worth anything as cost does NOT imply value.

This, of course, all means that the value of the company is limited to the $10 made up of the two $5 Federal Reserve Notes. The certificate for one share that it holds adds no value, and even if an additional million shares were held, there would be no increase in value.

Because of length, I will break up the answers
into separate comments.

Regards, Don

Question # 2a -- When one of

Question # 2a --

When one of the $5 Federal Reserve Notes in the envelope is transferred to me, this is equivalent to the company paying a cash dividend of $5 per share. The company is now worth $5 less, but I end up whole as I now hold the $5 directly, rather than it being part of the company of which I am the sole owner and shareholder. My brother is not impacted by this transfer.

Question #2b --

When one of the $5 Federal Reserve Notes is transferred to my brother, this is equivalent to cash compensation. The company is worth $5 less and I am equally impacted by the reduction of value in my holding in the company. My brother, of course, is $5 to the good.

Question #2c --

When the one share stock certificate is transferred to me, this is equivalent to a 2 for 1 stock split. Since I still own 100% of the company and the company still has two $5 FRNs, there is no change in value of the company and no change in the total value of what I own, now having 2 shares worth $5 each instead of 1 share worth $10. My brother is not impacted.

Question #2d --

When the one share stock certificate is transferred to my brother, this is equivalent to a stock grant, possibly as compensation. The value of the company does not change, but I have lost $5, half of the company's value, which now belongs to my brother, who is $5 richer.

Note that the result of 2d, the stock transfer to my brother, is exactly the same as if the one share certificate had first been transferred to me as a stock split, and then given by me to my brother.

This is one of many reasons that it makes no logical or economic sense to record a company expense from a stock (or option) grant unless stock splits are also recorded as expenses, which is, of course, absurd.

Regards, Don

Off-topic question: If I'm

Off-topic question: If I'm not using Movable Type myself, is it possible for me to post a trackback? I don't know how that system works.

Cap'n, If you click on the

Cap'n,

If you click on the "trackback(0)" beside the author name and date, you will see a trackback url. Usually, other blogs "ping" to this url. I know that pMachine blogs can ping MT blogs, so there should be a way for anyone to do so, though I don't know anything more specific than that. You might try the support forums at movabletype.org.

Cap'n, JTK of "No

Cap'n,

JTK of "No Treason!":http://www.no-treason.com knows how to ping an MT site with pMachine, try asking him.

What's pMachine? I found

What's pMachine?

I found some info and have been trying to do it manually through telnet, but so far no luck. Server's telling me it needs a source URL even though I'm pretty sure I sent one. Sigh. Wish the server would echo back what it thought I sent it... :)

I thought this way, also,

I thought this way, also, until I read FASB's explanation of its recommendation that options be expensed.

FASB points out that any time the company writes an option contract as payment for anything except employee services, it must be treated as a liability incurred to acquire some asset. The only time this does not happen, is when it is a payment for labor. This irregular practice does not improve the quality of accounting at firms.

The FASB report deals with a number of other objections, which the limited space allowed for notes does not allow me to mention.

cw, "...FASB points out that

cw,

"...FASB points out that any time the company writes an option contract as payment for anything except employee services, it must be treated as a liability incurred to acquire some asset. The only time this does not happen, is when it is a payment for labor. This irregular practice does not improve the quality of accounting at firms...."

Your comment is appreciated. I would have responded directly if you had not provided a dummy email address. Hopefully you'll see this if you specifically look for it.

I am forced to assume that when the FASB says 'the company writes an option contract as payment' that it not referring to options on its own stock, but rather options on some arbitrary asset unnamed.

If this is true, it is a further strong indication that the FASB is completely at sea on the whole question of stock and option expensing.

The primary reason that stock and option grants should NOT be expensed is that the underlying stock is NOT an economic asset to the company itself. It is, or should be, completely accounted for by the share count dilution of the existing shareholders. Thus the tying together of things that only share the word 'option' in their description is ludicrous. It would be like saying that everything that is paid for by bank check must be accounted for in the same way, no matter how much they differ.

Thanks, Don

An email, above. I always

An email, above. I always worry about it getting harvested from comment boards.

Also, FASB addresses counter-arguments:
http://www.fasb.org/draft/ed_sbp_appc.pdf

Put simply, my original concern about this issue was the following:

Firm value = NPV(future cash flow)
EPS = Firm value/# shares.

Then options should reduce EPS by increasing the denominator not the numerator.

FASB dispenses with this argument quite handily. Many firm policies affect both the numerator and denominator of EPS. In addition, EPS is a metric that is not a central consideration for GAAP (see C31 in above document).

FASB argues from the point of view that the firm is consuming its labor assets, and this must be accounted for under expenses under double-entry bookkeeping:

"C15. To summarize, accounting for assets received (and the related expenses when
consumed) has long been fundamental to the accounting for all freestanding equity
instruments except one?fixed equity share options that have no intrinsic value at the
grant date and are accounted for under the requirements of Opinion 25. This Statement
remedies that exception."

From the accounting perspective (which is not the same as a financial model of the firm), options on the firm's shares are not a free good. By treating them as a free good, GAAP has introduced a bias towards a certain type of compensation, which is inefficient.

Finally, the intended meaning of my original post was that firms must account for all other options contracts _on their own shares_ as expenses, except in the case of labor compensation.

cw, Thanks for the

cw,

Thanks for the info.

Regards, Don